Clever use of debt can be key to business and personal financial success. In fact, this is the strategy that the world’s most affluent companies and individuals use to accumulate wealth.
With the right approach, it is possible to use debt to grow wealth in South Africa. That said, this usually requires a strong starting point – in line with the adage that it takes money to make money – and some tolerance for risk. Below we explore the issues and offer practical examples of ways to use debt to make money.
Good debt vs. bad debt
Differentiating between good and bad debt is the first step to wealth creation.
Essentially, good debt is borrowing money to fund an investment, project or purchase that is likely to appreciate in value or provide an immediate financial return.
In contrast, taking out a loan to pay for an expensive holiday, clothing or other consumable is bad debt. Instead of growing wealth, bad debt can have the opposite effect by negatively impacting your credit score and making it more expensive to borrow again in the future.
That said, it’s not always possible to avoid bad debt. During tough times, individuals and companies may be forced to take on bad debt.
For those who are comparably well off, it’s much easier to use debt strategically, in ways that have long-term financial advantages.
Leveraging debt: the basics of wealth creation
Both businesses and individuals can leverage debt in a number of ways that ultimately generate more wealth.
1. Investment in real estate: the classic example
Using borrowed funds to buy real estate is the classic example.
Here’s the thinking. You use someone else’s money (usually the bank’s) to purchase property. You rent out the property to tenants, and use their monthly rental payments to cover your bond repayments.
Eventually, you own a property that you didn’t spend your own money to purchase.
The value of the property will have continued to appreciate. Once the bond is repaid, tenant payments go to your pocket, or you can sell the property for more than its original price.
Or you can use the property as equity for another loan and add further properties to a growing portfolio.
An important caveat: In practice, things rarely proceed so smoothly! Tenants may default on rental payments or contribute to costly damage, maintenance costs can run high, interest rate increases jack up bond repayments, the property market may hit a dip, you get hit with taxes and so on.
Nonetheless, the underlying logic is compelling. Most ways to use debt to grow wealth follow a similar pattern: using borrowed funds to acquire (or strengthen) assets that will make you money.
2. Business expansion: how borrowing can fuel growth and profits
Borrowing money to accelerate business growth and unlock profits is a savvy way to use debt.
A loan can be used to finance an exciting business opportunity, invest in equipment, machinery or technology or cover the cost of specialised skills.
When debt is used to streamline operations and maximise profits, it typically pays off.
3. Use debt for stock market investments
Investing in blue chip shares can be an easy way of using debt to accumulate wealth.
Dividends can help pay off all or part of the debt. The shares can be sold at the top of the market or retained as part of a long-term diversified financial portfolio.
This type of investment can be risky as the markets are notoriously volatile.
4. Educational loans: investing in skills and knowledge
Leveraging debt to pay for a course, degree or advanced skills training is a good way to build wealth.
Investing in education increases long-term earning capacity, which offsets the original cost of the loan.
5. The role of debt in start-ups and entrepreneurship
Debt financing is an invaluable tool for start-ups and entrepreneurs.
It is essential to business growth and expansion, typically cheaper to raise than equity, and allows the founder to maintain complete control of operations.
6. Leveraged buyouts: acquiring business assets with debt
Using other people’s money to buy an established business can be advantageous.
When there is an existing customer base, steady revenue stream and sound business infrastructure, a buyout is a quick and relatively low risk means of accumulating wealth.
In addition to acquiring a profitable business with the potential to expand, there’s the added benefit of immediate income generation.
7. Refinancing and consolidation
Some debt, such as credit-card repayments, are more expensive to service. Interest rates can be two or even three times higher than other types of debt.
When there are multiple loans to repay, it is often easy to lose track and miss a payment. This can increase the overall cost of the debt.
Taking out a single loan at a lower rate of interest to pay off all the other loans reduces the amount paid each month. It’s easier to manage and allows you to pay off the debt more quickly.
Tax benefits: how debt can enhance wealth creation
When used strategically, debt can have a range of tax benefits.
It can finance the purchase of appreciating assets – shares, artworks and rare collectibles – that are only taxable when sold.
Income in the form of loans is not liable for income tax.
Purchased assets may also be used as equity, to secure further loans. Upon death of the owner, they can also be passed directly to members of the family – completely circumventing capital gains tax.
What we do and don’t offer at LoanAgainst
We are not consultants and do not offer financial advice about investments or portfolios. (For that, we recommend speaking with a professional financial adviser).
What we do offer is fast, convenient loans against movable assets, ranging from vehicles to jewellery or works of art. We offer flexible repayment terms, competitive interest rates and the option to extend loan periods if payments are up to date.
Call us on 064 976 7106 for more information or simply complete and submit our online loan application.
